Retention Ratio

The retention ratio formula indicates the percentage of a company's earnings, which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the firm's development and how much is getting distributed as dividends to the shareholders.

Retention Ratio = Retained Earnings / Net Income

Or

Retention Ratio = 1- Dividend Payout Ratio

The size of the plowback ratio will attract different types of customers/investors.

• Income-oriented investors would expect a lower plowback ratio, suggesting high dividend possibilities to the shareholders.
• Growth-oriented investors will prefer a high plowback ratio implying that the business/firm has profitable internal usage of its earnings. This, in turn, would push up the stock prices.

Suppose the plowback ratio is close to 0%. In that case, the firm is more likely to be unable to maintain the existing levels of dividends since it is distributing all returns back to the investors. Thus, sufficient cash is not available to support the capital requirements of the business.

We see that Amazon and Google have a retention of 100% (they retain 100% of profit for reinvestments), whereas Colgate's ratio was 38.22% in 2016.

Let us look into some of the examples for easier understanding:

Assuming Company 'Z' reported earnings per share of $100 and decided to pay $5 in dividends. With the above formula, the Dividend payout ratio is: $5 / $100 = 20%

This means Company 'Z' distributed 20% of its income in dividends and re-invested the rest back in the company, i.e., 80% of the money was plowed back into the company. Thus,

Retention = 1 – ($2 / $10) = 1- 0.20 = 0.80 = 80%

Below is another example of taking a comparison of 2 companies for improved understanding:

The plowback ratio of Company' X' suggests that they have struggled to find any profitable opportunities. Perhaps, the firm does not have many opportunities and thus will be distributing a reasonable portion of its earnings as dividends. This could also be a temporary tactic to keep many shareholders satisfied and enhance stock prices for the immediate future.

Concerning Company' Y', lower retention and negative cash flows highlight that they have invested heavily in futuristic projects and may have retained sufficient earnings for future opportunities.

Some of the uses of Retention Ratio

• It is easy to calculate and suitable for a ball-park comparison amongst firms/sectors.
• The ratio can work in tandem with the dividend payout ratio to plan the future ideas of the firm.

You can use the following Retention Ratio Calculator

Let us now do the same example above in Excel. This is very simple. You need to provide the two inputs of Dividend and EPS. Then, you can easily do the Retention ratio calculation in the template provided.

Below is another example of taking a comparison of 2 companies for improved understanding:

You can download this Retention ratio template here - Retention Ratio Excel Template.

It is necessary to understand the investor expectations and capital requirements vary from one industry to another. Thus, a comparison of plowback ratios will make sense when the same industry and companies are made. There is no specific bracket within which the retention ratio should fall, and various other factors have to be considered before concluding the future opportunities of a company. It should be considered just an indicator of possible intentions made by the company.

This has been a guide to the Retention Ratio. Here we discuss the formula to calculate retention ratio along with practical examples and its uses and relevance. You may also have a look at these articles below to learn more about Financial Analysis –

• Calculate Win/Loss Ratio
• Compare - Trailing PE vs. Forward PE Ratio
• Types of Equity Compensation
• Formula for Risk Ratio